Tuesday, October 19, 2010

This viewpoint makes research harder because you can't really use fixed time-period returns data that well anymore - one year returns are sort of meaningless in a flexible timeframe environment, because I don't care what the one year returns are, I care what the annualized return between now and the time I choose to sell is. There's a continuous option to sell in the interim, so one year returns aren't that helpful.

It's "one year returns" (or some other fixed time horizon) that make volatility work, which is probably why people got sidetracked onto that path.

As an alternative, perhaps we can look at the price arc after purchase- something like "time to reach estimated intrinsic value" (or, more accurately, some discount to estimated intrinsic value, the discount being relative to uncertainty surrounding intrinsic value.). If you needed to model that, I suppose you could model with something stochastic, with a drift towards expected value whose magnitude is as a percent of the distance to expected value? Something like that? That lets one mathematically model what is more anecdotally obvious.

One can model "discount to estimated intrinsic value", as well - just as we care about having positive one year returns, we care about a narrowed discount to estimated intrinsic value - but that doesn't account for the amount of time it takes you to narrow that discount.

Just food for thought as a replacement for "one year return" data as a Y variable (where you'd probably want to transform "time to reach estimated intrinsic value" so that better investments are more positive - but there are a number of easy transforms for that).

Friday, October 15, 2010

This is something economists seem to have a very hard time with, and I've been meaning to write about for a while.

Imagine an asset, "Safey the Asset", that pays out $10 a year forever. First payment is immediate.

The value of this stream is 10 + 10/d + 10/(d^2)...

After each payment, the value of the stream drops (the 10 up front goes away) by a factor of d, and then increases at a constant rate back up to initial value before dropping again at the next dividend. Volatility of the stream is low; incorporate the dividend and reinvest it at d, and the volatility is 0.

Now imagine a company, "Nukey the Power Plant", that with 99% probability pays out $10 and lets you roll again next year. First "dice roll" is immediate.

There is a 1% probability that it will pay out nothing and its assets will explode, never yielding any more cash.

For discount rate d, the value of this stream can be determined probabilistically:

There's a 1% chance this is worth 0

There's a 99%*1% chance this is worth 9.9

There's a 99%*99%*1% chance this is worth 9.9 + 9.9/d

There's a 99%*99%*99%*1% chance this is worth 9.9 + 9.9/d + 9.9/(d^2)

etc.

The exact value of the stream depends on d, but you'll notice that the value of this stream can stay pretty close to constant. In exactly one year, if the assets didn't explode, the value of the stream will be determined by:

There's a 1% chance the rest of the stream is worth 0

There's a 99%*1% chance this is worth 9.9

There's a 99%*99%*1% chance this is worth 9.9 + 9.9/d

There's a 99%*99%*99%*1% chance this is worth 9.9 + 9.9/d + 9.9/(d^2)

The price will be the exact same in one year as it is today. Like Safey, it will fluctuate in the interim only due to time value of money effects, which is determined by the size of d, and is pretty small - for a d of 10%, the value of the stream drops 10% when the money is paid out, and then climbs at a constant rate back up to initial value until the next dividend is paid. Again, observed volatility of the stream is low; incorporate the dividend and reinvest it at d, and the observed volatility is 0.

Of course, there's that pesky 1% - if you get very unlucky, your entire asset is destroyed.

You'll notice here that observed volatility and risk have nothing to do with one another. You could go for 100 years constantly just seeing 10% price fluctuation ignoring the dividend as you win every time - on an observed volatility basis, Nukey and Safey are identical.

Perhaps the "intrinsic volatility" of Nukey is higher, because it incorporates unseen events, but intrinsic volatility is a) completely unobserved and b) completely uncorrelated with observed volatility.

This link between observed volatility and intrinsic volatility is an assumption of most finance papers, but I'd posit that it's very, very wrong.

In case you think I'm making up random examples, this "Nukey the Power Plant" asset fits the profile of a lot of different types of assets - oil rigs and power plants (ignoring energy price fluctuation - the point is the stream continuing or not), tech companies (you have unmatchable products with no competition and incredible margins... until someone comes up with something better and you lose your profit stream), event-related insurance (super cat, property, reinsurance, etc), banks (hello last 3 years), pharma (FDA pulling approvals), even fashion (you're the hip look til you're not), etc... there's almost no types of company this type of risk is NOT relevant for. I'd say the "it could go to 0" component of the risk is a much more important risk than the "look at the price of the asset oscillating" risk.

I define open-ended assets as assets without a fixed point at which you sell or exercise the asset. So an American option is a closed end asset, because you have a specific amount of time to derive value from the option but can do so anytime in the interim. I think it's pretty easy to see why volatility matters. A bond is similar.

However, equities can be held until whenever it is that their price is good - if you can observe an underlying value that others are not seeing, this value is increasing, and that price moves stochastically with a drift towards the intrinsic value, you can buy an equity and hold it for as long as it takes to get to the intrinsic value. If the price drops, or undergoes a lot of volatility in a region that is nowhere near intrinsic value, that doesn't imply more risk, because value keeps increasing and price will eventually move towards underlying value. The longer it takes, the higher value is and the more price appreciation you'll see. The path doesn't affect the endpoints.

Thus, observed volatility is only relevant to risk if there IS no disconnect between price and value. In this case, prices need to constantly reflect all public information, at least, meaning you require the semi-strong form EMH.

I'd caution you against subscribing too strongly to semi-strong EMH. These are the same people who think that Renaissance Capital and Warren Buffett and George Soros "just got lucky" - I'd recommend "The Superinvestors of Graham and Doddsville": http://www.fusioninvesting.com/Files/reading/superinvestors.pdf I can imagine a response of either "Buffett's cherry picking" or "they just chose a method which happened to randomly work for that time period but there's no proof it will continue...." You're welcome to your opinion, but the theoretical grounds for the method were there before the method worked, were justifiable by economic theory excluding EMH, and were not rationalized ex-post. As I say to dedicated members of political parties all the time, watch out for your own confirmation biases when it comes to EMH.

Tuesday, October 12, 2010

I'm looking at Gencor (ticker: GENC), a company whose market cap is
significantly less than current assets minus total liabilities (a
"net-net"), and seems to actually have a legitimate profitable
business making capital equipment for asphalt production, as well.
Obviously, as an investor, this piqued my attention, but there are
some really funny things going on:

1) Doubtful accounts receivable runs about 1/3 of their entire
accounts receivable and has for the last 8 years. It looks like a
normal 30 day payment period (I'm sure this is buried somewhere in the
footnotes, but receivables turnover is in the general vicinity of 10),
so its not a "it collects its bills so fast that the only ones left
are doubtful ones' story (which I've never heard of but would be
theoretically possible). Thus, I can't figure out why they keep
selling to lousy customers. Perhaps there's a legitimate reason why
this would happen other than fraud (if it's fraud, for example, why is
it declared as doubtful - normally that stuff gets hidden), but it
does inflate revenues when announced and the writeoffs are less
prominent.

2) For some reason their marketable securities purchases are listed as
operating cash flow when clearly municipal bond and equity investing
are investments, not operations, for an asphalt equipment production
company. I can't figure out why this is happening, I've never seen
this in a company whose business was not in the financial sector and
had no idea this was allowed. This is weird, because it makes their
Operating Cash Flow look way too low and Investing Cash Flow look too
high. Most frauds fake high operating cash flow, not low operating
cash flow.

3) At the end of 2008, they had one CFO resign "for personal
interests" after working there for 8 years (this is a tiny company, I
doubt he's rich enough to retire), replaced him with someone else (not
interim, as far as I can tell, because they don't say so and they go
out of their way to mention he actually relocated with his entire
family from Connecticut to Florida), and then 5 months later the new
guy quit with no warning and no publicized letter or reason. 3 months
later they announce another new CFO. The departure of the second CEO
is found in an 8-k with an accompanying press release on the SEC
website, but that press release is not listed in the section for press
releases on their website, though all the surrounding ones from the
same time periods (earnings reports, etc) are. There are just two "New
CFO!" press releases.

4) They had an activist investor who accumulated a big position,
joined the board, supposedly (according to the CEO) never went to a
meeting, and resigned from the board suddenly and sold everything a
few months later. Unlike most board resignations ("It's been an honor
to work with these people and I am sure the company will see brighter
things to come", or something like that - as seen in the first CFO's
resignation), his resignation letter was about as terse as it gets:
"Dear Sir or Madam: I hereby resign as a member of the Board of
Directors of Gencor Industries, Inc. effective May 7, 2008. Sincerely,
Lloyd I. Miller, III"

5) I know I'm not Obama's biggest fan, but the CEO directly rips into
Obama IN THE COMPANY'S OFFICIAL PRESS RELEASES AND 8-KS. At the very
least, it's unprofessional.

"In view of the accelerated trading of the Company's stock [after the
resignation], and for the benefit of those who persist on remaining
uninformed in spite of all of Gencors (Nasdaq:GENC) SEC filings,
10-K's, 8-K's, Proxy Statements, Annual Reports and Press Releases..."

"The Company is actively engaged in exploring acquisitions, and when
one such is under contract the information will be issued" (Firstly,
what a terrible way to run a company, but secondly, it's been two and
a half years, with more bargains on the market than anytime in
history, and they have cash to burn, and still no acquisitions...)

"Mr. Lloyd Miller only attended the Board meeting immediately after
being elected to the Board on March 6, 2008. At that Board meeting he
was elected to the Audit Committee but never attended one of it's
meetings and then resigned from the Board on May 7, 2008, and based on
recent conversations with management, he did so purely for personal
reasons and convenience and maintains a professed high esteem for the
company, its management, and its future." (If you say so...)

"Disinformation and rumors only serve the purposes of the self-serving
speculators preying on the uninformed investors."

7) They quote a "James Zeller, US Asphalt" as saying they are
wonderful about service when US Asphalt bought equipment. I googled
James Zeller, and saw a Jim Zeller on the Sales team at a different
asphalt company. Not a major finding, but most sales guys don't buy
capital equipment, and he's changed his company if it's really him. I
have to imagine it's the same guy - there can't be too many James
Zellers in the US working in asphalt.

8) In other trivial but interesting findings, they claim to have a
24/7 help desk but don't have the number anywhere (what, does every
contractor know the number by heart?)

9) I cannot find a single place other than a nebulous "contact us"
form with no other information given to figure out how to BUY THEIR
PRODUCTS. They don't list distributors, they don't say to email them
for a quote or call them for a quote, they don't pop up on google when
I write "Gencor purchase" or "Bituma purchase" (one of their brands).
I understand their products aren't exactly going to pop up on Amazon,
but usually places like this will give you the ability to contact
their sales staff. There's a general corporate line on their website,
which a person does pick up. I haven't pursued anything by phone further.

10) Despite the amount of cash they have, they have had no dividends or buybacks at all. At best, this is a symptom of bad management, but in context, it makes you wonder how much actually exists.

11) In their defense, their corporate headquarters does in fact pop up
on google maps, and the street photo clearly has their logo. It looks
like they have equipment there, though there's no guarantee they don't
share the building.

I'm wondering if maybe the CEO wants to run a mutual fund or
something, which is why he holds the cash and makes Investing cash
flow look too high, etc. But that's reaching at straws, it's not a
normal thing. This is really, really weird. None of this stuff
individually screams "fraud" but all together it starts getting
interesting. The problem, of course, is that shorting a net-net that
also generates cash is asking for trouble if the company is real. I'll
keep investigating.

Monday, October 11, 2010

Another in a series of "Real Life Economics" examples I've been putting together for people interested in economics, or taking introductory economics, for how economics actually affects the real world.

Credit for this one goes to Paul Krugman, pre-intellectual suicide, and Greg Mankiw.

This is the "most basic" scenario of how a recession happens, laid out by Krugman. The link also introduces things like interest rates to complicate this basic outline

"The Sweeneys tell the story of--you guessed it--a baby-sitting co-op, one to which they belonged in the early 1970s. Such co-ops are quite common: A group of people (in this case about 150 young couples with congressional connections) agrees to baby-sit for one another, obviating the need for cash payments to adolescents. It's a mutually beneficial arrangement: A couple that already has children around may find that watching another couple's kids for an evening is not that much of an additional burden, certainly compared with the benefit of receiving the same service some other evening. But there must be a system for making sure each couple does its fair share.

The Capitol Hill co-op adopted one fairly natural solution. It issued scrip--pieces of paper equivalent to one hour of baby-sitting time. Baby sitters would receive the appropriate number of coupons directly from the baby sittees. This made the system self-enforcing: Over time, each couple would automatically do as much baby-sitting as it received in return. As long as the people were reliable--and these young professionals certainly were--what could go wrong?

Well, it turned out that there was a small technical problem. Think about the coupon holdings of a typical couple. During periods when it had few occasions to go out, a couple would probably try to build up a reserve--then run that reserve down when the occasions arose. There would be an averaging out of these demands. One couple would be going out when another was staying at home. But since many couples would be holding reserves of coupons at any given time, the co-op needed to have a fairly large amount of scrip in circulation.

Now what happened in the Sweeneys' co-op was that, for complicated reasons involving the collection and use of dues (paid in scrip), the number of coupons in circulation became quite low. As a result, most couples were anxious to add to their reserves by baby-sitting, reluctant to run them down by going out. But one couple's decision to go out was another's chance to baby-sit; so it became difficult to earn coupons. Knowing this, couples became even more reluctant to use their reserves except on special occasions, reducing baby-sitting opportunities still further.

In short, the co-op had fallen into a recession.

Since most of the co-op's members were lawyers, it was difficult to convince them the problem was monetary. They tried to legislate recovery--passing a rule requiring each couple to go out at least twice a month. But eventually the economists prevailed. More coupons were issued, couples became more willing to go out, opportunities to baby-sit multiplied, and everyone was happy. Eventually, of course, the co-op issued too much scrip, leading to different problems ...

If you think this is a silly story, a waste of your time, shame on you. What the Capitol Hill Baby-Sitting Co-op experienced was a real recession. Its story tells you more about what economic slumps are and why they happen than you will get from reading 500 pages of William Greider and a year's worth of Wall Street Journal editorials. And if you are willing to really wrap your mind around the co-op's story, to play with it and draw out its implications, it will change the way you think about the world....

...Above all, the story of the co-op tells you that economic slumps are not punishments for our sins, pains that we are fated to suffer. The Capitol Hill co-op did not get into trouble because its members were bad, inefficient baby sitters; its troubles did not reveal the fundamental flaws of "Capitol Hill values" or "crony baby-sittingism." It had a technical problem--too many people chasing too little scrip--which could be, and was, solved with a little clear thinking. And so, as I said, the co-op's story helps me to resist the pull of fatalism and pessimism."

And secondly, Mankiw. You'll notice that this "babysitting economy" requires two sides - it requires both someone willing to work (babysit) and someone willing to consume. Imagine that some people had accumulated lots of babysitting coupons and others had accumulated very few - in other words, there is "poverty" and "wealth" in the economy. Imagine that each year, the 10% with the most coupons had to give 20% of their coupons above the average amount to the 10% with the least coupons. How does this affect willingness to work for everyone involved? (For Graham this question is not optional).***see stars below for one answer***

Which brings us to Mankiw's column today, already cited earlier in my blog:

"HERE'S the bottom line: Without any taxes, accepting that editor's assignment would have yielded my children an extra $10,000. With taxes, it yields only $1,000. In effect, once the entire tax system is taken into account, my family's marginal tax rate is about 90 percent. Is it any wonder that I turn down most of the money-making opportunities I am offered?

By contrast, without the tax increases advocated by the Obama administration, the numbers would look quite different. I would face a lower income tax rate, a lower Medicare tax rate, and no deduction phaseout or estate tax. Taking that writing assignment would yield my kids about $2,000. I would have twice the incentive to keep working. "

***This is not to say that we shouldn't help out people who need babysitting, but it does very much skew the incentives to work - those with few coupons don't need to work as hard because they'll get coupons (and the more they work, the less they'll be given), and those with lots of coupons don't want to work as hard because for each "coupon" they earn, they're actually only earning .8 coupons. The Mankiw article indicates that for many, they're actually only earning .1 coupons... which should make everyone very worried about the babysitting equilibrium put forth by Krugman...

"HERE'S the bottom line: Without any taxes, accepting that editor's assignment would have yielded my children an extra $10,000. With taxes, it yields only $1,000. In effect, once the entire tax system is taken into account, my family's marginal tax rate is about 90 percent. Is it any wonder that I turn down most of the money-making opportunities I am offered?

By contrast, without the tax increases advocated by the Obama administration, the numbers would look quite different. I would face a lower income tax rate, a lower Medicare tax rate, and no deduction phaseout or estate tax. Taking that writing assignment would yield my kids about $2,000. I would have twice the incentive to keep working. "

Thursday, October 7, 2010

Periodically I come across things that I think are good examples of why studying econ is useful. Time for a pop quiz. Explain what is wrong with this assertion (the entire email is below, if you need more information on what the law actually says):

What does the Law say?

Known as Chapter 40B the law says that all communities must have a minimum of 10% affordable housing and streamlines the permit process for construction as a way to eliminate exclusionary zoning processes and prevent individuals from being priced out of their communities. [MY NOTE: In practice, this means that 10% of the rooms in every building is reserved for "affordable housing"].

What happens if this [mandated affordable housing] law goes away?

12,000 affordable homes will never be built. This will cause the state to [lose] jobs and individuals across the state to not have access to adequate housing. Essentially NO affordable housing will be built outside of the major cities and Habitat for Humanity will not be able to adequately operate in MA.

Graham this is not an optional response for you.

(answer below- scroll down)

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My response looked something like this:

"Setting aside whether affordable housing laws do good things (there are legit arguments on both sides - I tend to think they're an inefficient solution to poverty and should be replaced with more impactful poverty policies, but I see the argument for them)... how does a mandate that developers make 10% of their units unprofitable drive away jobs? Eliminating affordable housing laws, thus making units more profitable, actually would create construction jobs because projects that couldn't be viable now would become viable..."

[I'm also very interested in hearing why Habitat for Humanity would be forced to cease operation... is it a land issue?]

Did you know affordable housing in Massachusetts is under attack? Question 2 on the November 2nd ballot seeks to eliminate MA's primary affordable housing law

What does the Law say?

Known as Chapter 40B the law says that all communities must have a minimum of 10% affordable housing and streamlines the permit process for construction as a way to eliminate exclusionary zoning processes and prevent individuals from being priced out of their communities

Has the law been successful?

Yes. the law has created 58,000 affordable homes for seniors and working families. The law has helped 51 cities in towns get to 10% and incentivized another 150 to come up with a plan to reach that goal.

What happens if this law goes away?

12,000 affordable homes will never be built. This will cause the state to loose jobs and individuals across the state to not have access to adequate housing. Essentially NO affordable housing will be built outside of the major cities and Habitat for Humanity will not be able to adequately operate in MA.

Why should you care?

A study from Northeastern shows that the cost of housing for recent graduates will skyrocket if the affordable housing law is removed. MA is an expensive place to live and under the law a single individual making up to $44K a year qualifies for affordable housing.

The law has also been used to help seniors who do not have pensions remain in their communities and is part of the "housing first" solution to homelessness. Furthermore it provides stability to families and entire communities in a time where the economy can put someone at risk of losing their home.

Who is protecting affordable housing and Voting NO on 2?

Over 1,500 individuals and organizations including all 4 candidates for MA governor, the League of Women Voters, Habitat for Humanity, the YWCA, City of Cambridge, and Catholic Archdiocese.

Who came up with the idea for question 2?

An organization known as the Slow Growth Initiative, funded by the New England Coalition for Sustainable Population that advocates for population control (We literally can't make this up)

How you can help?

Please e-mail **** or ****** for more information or if you have questions.

Whether you have 5 minutes or 5 hours, any time you can give protects our seniors and working families.

"Interestingly, CAPS members think Zion has a better chance of finding oil in the Middle East than Tesla has of making it as a mainstream car company."

In that case, Tesla must be much, much worse of a company than I had ever realized. Uh oh. Not to say they can't turn it around, but if CAPS investors are even reasonably on top of the fundamentals of the companies (which is reasonable - maybe they're imperfect as predictors, but as reflections of current state, they're not bad)... bye bye, Tesla...